Animal Spirits

October 30th, 2012

by Eric Schaefer

In 1936, The General Theory of Employment, Interest and Money, by the eminent English economist John Maynard Keynes, was published. While The General Theory was Keynes' broadside against several assumptions underlying orthodoxy classical economics, two, in particular, were in his sights.

The first was the idea that supply (whether it be of labor, capital or land) creates its own demand. This notion was at the heart of the idea that in a perfect world, demand and supply would always equal, enabling the economy to reach equilibrium. The second was the intellectual construct of homo economicus (or, economic man), the primary actor at the center of classical theory.

Keynes dismissed the idea in the real world that supply always creates its own demand. If so, then economics lacked a cogent explanation for not only The Great Depression (which still lingered on in Britain and the United States in 1936) but for the panics, contractions and downturns which periodically beset free market economies. To Keynes, it was only by happenstance that supply ended up equaling demand; so it was not unusual for activity to become stuck below an economy's potential.

In the Keynesian model, an imbalance between savings and investment was responsible for these gaps. Keynes contended there was no guarantee that investment spending would soak up savings. There would be times — and The Great Depression was such an occasion — when businessmen's animal spirits would fail them, resulting in a general want of confidence.

Businessmen were not the rational calculating engines assumed in classical economic theory: quite the contrary, Keynes contended. In his view, businessmen acted on hunches and intuition; only the rare specimen evaluated the probabilities of the range of possible outcomes to compute the expected gain or loss from a course of action. Most relied on their gut when moving forward with a new investment or venture. Thus, there would be times then when businessmen lacked the confidence or animal spirits to engage in potentially lucrative but risky endeavors.

As a model of business psychology, Keynes' explanation for the persistence of The Great Depression offers insights to the tenacious grip of The Great Recession. There is an air of uncertainty in the current business climate, induced by a number of factors. The ongoing European sovereign debt crisis, the slowdown in China and lingering concerns over the fragility of the world's financial system are some of the macro themes inhibiting risk taking.

Politics in the U.S. has also clouded the picture. Industry leaders have voiced concerns that they cannot see past January 1st, 2013 — the date of the so-called "Fiscal Cliff" when the Bush-era tax cuts, the temporary fix to the Alternative Minimum Tax (AMT), the Social Security tax holiday and other measures expire. In addition, there are the festering, unresolved fiscal problems posed by Medicare and Social Security, the ultimate costs associated with the Patient Protection and Affordable Care Act (aka, Obamacare) and the unrelenting rise in health care costs. Together each item frustrates businesses' attempts to forecast their employee benefit costs with any degree of certainty beyond 2013.

The weight of uncertainty is perhaps the reason why the rate of new business establishment is at a secular low. We discount the lingering effects of recession alone as the excuse for the current malaise. In prior recessionary periods, new business formation displayed a strength (despite the obvious economic challenges) absent today. So of all of the initiatives Washington can undertake to move the economy forward, we believe dispelling the cloud of uncertainty is the most vital. By taking action and removing doubt, politicians can help businessmen find their animal spirits.

Notes on Sources and Methods:

The chart was assembled from data compiled by the Census Bureau in its ongoing longitudinal survey of business formation in the United States as part of its collection of Business Dynamics Statistics (BDS).

The period covered is from 1977 through 2010. The new establishment creation rate (the blue bar) is the ratio of newly formed business entities to average of existing business entities. The number of business entities exceeds the number for firms in the United States. The reason is a firm may have multiple operating entities, particularly if there are subsidiaries or divisions in different states. In 2010, the creation rate was 10.1 percent versus a average (over the 34 years) of 12.7 percent.

We also illustrate the proportion of new jobs created in a year by new establishments to the total new jobs created by all establishments (the red dashed line). In 2010, this proportion was 16.9 percent versus a 34 year average of 18.5 percent.

Both series suggest businessmen and women remain reluctant to undertake new initiatives. In comparison, during the 1980 to 1982 recessionary periods, new establishment and associated job creation advanced at a brisker pace despite the burdens of a sharp contraction in economic activity and high interest rates.

(Sources: Census Bureau; and, AIFS estimates.)

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